India: the elephant in the room

India has a wealth of prospective advantages it can leverage for its long run economic development. They span demography, scale, an accomplished diaspora, access to the Indian and Pacific oceans, crossing both the Asian and European time zones, its vibrant democratic institutions and its overall factor endowment. This potential has not yet been consistently converted into the sustained high growth rates experienced by the east Asian nations that have succeeded in attaining middle income status within the passage of a few generations.

In this edition of Prospects we consider what India might do to close that gap, allowing the Elephant in the room, with its 1.2 billion plus citizens, to ascend to the next level.

Following a short history lesson, we will put forth what India has been doing right of late. We will then survey which of the government’s likely policies will have the greatest positive impact on Indian living standards; while introducing some of the signposts we have identified to assess their progress over time.

Reform in fits and starts

India is a far more competitive and globally engaged economy today than it was two decades ago. India’s initial economic reform efforts were sparked by a balance of payments crisis in 1991 that forced it to reconsider its protectionist approach to trade, its centralised planning function and the complexity of its domestic regulatory systems. Since that time, reform has proceeded in fits and starts, and economic growth has fluctuated around its long run potential of around 7% based on both the impact of the reform agenda and the state of global demand.

India boomed in the mid-2000s on the back of strong private investment, funded by buoyant capital inflows and a hugely improved domestic savings performance. There was also strong demand for its exports, including the business process outsourcing phenomenon, where it emerged as a critical global hub. In internationally comparable volume terms, India’s economy doubled in size between 1991 and 2000; it doubled again between 2000 and 2007; and it is likely to double in size from its 2007 level this year.

Why has Indian growth slowed since the 2000-2007 period?

The three trends underpinning strong growth in the 2000 to 2007 period have been far less supportive since. The investment share of activity peaked back in 2011, slowing once fiscal stimulus was removed; capital flows have been erratic relative to the largesse available to emerging markets prior to the global financial crisis (GFC); the savings performance of the domestic economy has been underwhelming as the efficiency of investment deteriorated; and the export share of GDP has levelled off. High inflation has undermined India’s international competitiveness at times, and prior to the most recent cyclical phase, its import bill was problematic courtesy of high rupee prices for both gold and oil – its two key imported ‘vices’ as a country. Coupled with a static reform agenda either side of the GFC, the country was left vulnerable to the taper tantrum of 2014, and was grouped as one of the “fragile five” emerging markets.

Strategic leadership emerges

Two important things happened near the end of this difficult phase. First, Narendra Modi was elected Prime Minister with a reformist, pro-growth mandate. Second, Raghuram Rajan, a distinguished global policy maker, was appointed Governor of the Reserve Bank of India. Together, they dramatically boosted India’s reputation with foreign capital providers – Rajan on the institutional investor side, Modi, along with an influential cabinet, from a multinational, foreign direct investment (FDI) perspective. Domestically, Modi successfully introduced and implemented a number of fundamentally sound policies including in taxation, cancellation of large denomination currency ("black money"), irrigation, individual identity, education, digitisation, electrification, real estate, subsidy rationalisation, corporate insolvency, signing up for the Asian Infrastructure Investment Bank, and increasing FDI access. Rajan lowered inflation, helped by the crunch in non-food commodity prices, reduced external financing vulnerability, designing policy independently of government influence, and was a strong advocate of bank restructuring.

When Rajan announced he was heading back to the University of Chicago at the end of his three year tenure the administration was presented with a further, highly visible opportunity to lay its reform cards on the table. Should they appoint a technocrat to follow in Rajan’s reformist footsteps? Or a politically savvy operator with a less independent mindset? The fact that Rajan’s very able deputy, Urjit Patel, was appointed as his successor, points to a desire to continue to pursue reform. Further, Patel now works with a monetary policy committee of experts, increasing the formal independence of the central bank. Suffice to say the Modi government handled the Rajan succession with its reform credentials very much intact.

What else can be done to build on this momentum?

India has already done a lot of things right in recent years. And the government’s forward agenda has great potential to consolidate and build on these changes to produce longstanding benefits for Indian living standards. The list below includes some of the major signposts we are tracking to assess the delivery and execution of these reforms. These signposts, if reached, will confirm our constructive long run view on India’s demand for energy and minerals across our diversified portfolio.

1.Improve tax collection at all levels and achieve more effective devolution to the states.

Signposts: Rising revenue share of GDP after allowing for changes in the code, reflecting greater compliance; successful implementation of the nationwide Goods and Services Tax (GST). The cancellation of high denomination cash bills, announced unexpectedly in early November 2016, will make it more difficult for the dark money economy to function, which is great news for the tax take.

2.Boost the share of public spending going towards the provision of public goods in both hard and soft infrastructure.

Signposts: Planned spending rising faster than general outlays; education and health spending rising faster than transfers/subsidies and the civil service wage bill.

3.Focus on improving irrigation techniques and raising agricultural productivity through the dissemination of scientific methods, increases in farm scale and water management.

5.Pursue identity initiatives and e-governance aggressively for improved transparency and effectiveness of the transfer system.

Signposts: Aadhaar registration trends, new bank account openings, share of e-government transfers, electronic submission of income tax returns, outsourcing issuance of passport and renewal processes. The cancellation of large denomination rupee bills will also help here by moving more individuals into the formal financial system.

6.Increase the amount of international and domestic competition faced by Indian firms.

Signposts: Execution of The Insolvency and Bankruptcy & Real Estate Laws, financial restructuring of public sector enterprises, bank balance sheet cleansing, passing the Land Acquisition Bill, moving up the rankings in the World Bank’s Ease of Doing Business and the World Economic Forum’s Global Competitiveness surveys, increasing the share of savings going into financial products rather than physical assets like gold.

Executing the reforms above will go a long way towards delivering on India’s undoubted promise, thereby lifting the living standards of its 1.2 billion plus citizens to the next level. And that can only benefit the rest of the South Asian region, the broader economy of the Indo-Pacific - and the world.